Is depreciation expense a fixed cost or a variable cost?

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Let’s revisit the terms Fixed cost and Variable cost and then we will discuss where depreciation cost/expense really fits.

Fixed costs are such costs that do not change with the change in activity level (e.g. units produced) with in the relevant range. Where relevant range can be defined in terms of time or activity level.

Variable costs are such costs that change with the change in activity level (e.g. units produced).

In both of the definitions above, one critical factor is that we associate the change in cost with the change in activity level. Costs can increase or decrease due to number of factors. But to be variable cost, change in cost is studied alongside with the change in activity level and all the other factors are ignored.

Also, if we get technical then variable cost most of the time show a clear correlation between the cost incurred and activity level. In simple words , cost incurred and activity level either has a direct or indirect relation with each other having considerably predictable correlation co-efficient.

Coming to the question, depreciation expense or depreciation cost can either be fixed or variable and this depends on the method adopted to measure depreciation.

There are number of methods to calculate depreciation but to simplify things I will stick to the methods mentioned under International Accounting Standard (IAS) 16: Property, Plant and Equipment. According to IAS 16 para 62 methods include:

  1. Straight-line method
  2. Diminishing balance method (also known as reducing balance method)
  3. Units of production method

Under straight line method, keeping other things constant, results in a constant charge over a useful life of the asset i.e. a fixed amount out of carrying amount of asset will be charged as an expense every year. Therefore, depreciation cost/expense calculated under straight-line method will be of the nature of fixed cost.

Under units of production method we connect the depreciation with the number of units produced or simply activity level. Simply saying, more the units produced, more the depreciation charge will be and if number of units produce decreases then depreciation will decrease as well. As this change in depreciation is due the change in activity level we can safely say that depreciation calculated under units of production method is of the nature of variable cost.

The most controversial method, for this question in specific, is diminishing balance method or reducing balance method.

According to some the depreciation calculated under diminishing balance method is of the nature of variable cost as it changes. Whereas some are of the opinion that as the rate applied to calculate depreciation is same over the year therefore, it is of the nature of fixed cost.

In my opinion depreciation calculated under diminishing balance method is “fixed” in nature. The reason is that the change in depreciation charge is not occurring due to change in activity level. Secondly, this change does not have any correlation with the change in activity level whatsoever. No matter what the change is in activity level, the depreciation calculated under diminishing balance method results in a decreasing cost over the useful life of the asset. So, I too believe that depreciation charge calculated under reducing balance method is of the nature of fixed cost.

But before this answer is concluded, I would like to highlight one thing. Most of the time the reason of segregating costs as fixed or variable is that we want to discuss whether a certain cost is relevant to the decision or not i.e. whether a certain cost is a relevant cost.

But as depreciation cost or depreciation expense is a non-cash item i.e. no cash flows are involved as depreciation cost is a mere estimate and NOT a real cash outflow and thus can never be a relevant cost, therefore, the discussion whether a depreciation is fixed or variable cost in nature might be pointless.

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